Swiss set to risk for security

A mindset change that sees assets allocated according to risk, not capital, as well as the physical splitting of the three separate funds it manages, is setting up the Swiss Federal Social Security Fund for a stimulating year. Amanda White spoke to managing director, Eric Breval.The end of 2010 was a busy tactical, strategic and operational time for the CHF 25 billion ($26 billion) Swiss Federal Social Security Fund. This culminated in the separation of the three funds it manages, as well as a change in its approach to allocating assets with risk now the leading determinant.

From an investment point of view, it also had to weather the euro bashing throughout the year, although as managing director, Eric Breval points out Switzerland is “an island in a stormy sea”.

Nevertheless the currency movements in that part of the world couldn’t be ignored last year, no matter how isolated the government and monetary structure.

Managing director, Eric Breval, says the Social Security Fund will probably report a return on invested assets of 4.9 per cent for the year.

The fund has set a principle of an 80 per cent hedge against all the major currencies.

“We got a whack over the head on all sides,” he says, but most Swiss institutional investors were hedged against the US$ but less so against the euro, so the Social Security Fund’s performance was relatively good.

“We hedge against all major currencies, including the euro as a principle, not as a tactical currency play. That principle hasn’t changed.”

Essentially a buffer fund, the Swiss Federal Social Security Fund manages the funds of the federal old age and survivors’ insurance (AHV), the federal disability insurance (IV), and the income compensation scheme (EO).

On September 27, 2009 the Swiss people voted on the supplementary financing of the disability fund. The vote was two-fold: to increase the value added tax (one of the income contributors to the fund) from 7.6 to 8 per cent, and to form a separate fund for disability insurance.

The AHV, which has been the chief lender to the IV (which still owes it $15 billion) gave the disability fund a one-off launch capital a gift of about $5 billion.

In addition to this one-off funding, the disability fund gets the additional 0.4 per cent VAT as part of its inflow over the next seven years.

This means the three funds will be separated for the first time, and while still managed by the same team, they will be steered according to their individual risk and liability profiles.

The funds each have different sources of income, and the reasons for paying benefits are all, also, variable. And this variability, as well as legal constraints on its investment style, dictates that all three fund typically invest in more liquid and conservative investments than some other institutional investors.

“The buffer fund has a shorter time horizon than most pension funds, and typically invests in less risky and more liquid investments,” Breval says.

Because the income is not always sufficient to cover the benefits and the federal disability insurance and income compensation scheme deficits, and to avoid the costs of frequent investment changes, an operating liquidity of around CHF 2-4 billion is maintained.

About half of the assets are managed in-house including bond and commodity portfolios, as well as tactical derivative overlay programs, including about half the currency overlays.

The internal staff has relative freedom when it comes to making investment decisions, and moving allocations around its strategic benchmark.

Coinciding with the splitting of the three funds, is a new approach to asset allocating, with a focus on risk, so that now each fund can potentially have a different risk budget, that varies according to its liability status.

“When we moved to this new approach on January 1, we didn’t make many transactions. The allocations didn’t change much but so far but our mindset has changed,” Breval says.

Staff management has a strategic asset allocation with set boundaries for the asset management. Given that risk exposure varies according to market volatility, these boundaries are used to increase or decrease exposure to risky assets. The overall allocations (all three funds combined) are approximately: Swiss franc loans 10 per cent; Swiss franc bonds 20 per cent; foreign currency bonds 40 per cent; equities 20 per cent; real estate 5 per cent; commodities 3 per cent; and cash and other tactical investments the remainder (this can be as much as 20 per cent).

“The asset allocation is constantly changing,” says Breval, a Swiss-American who has worked for the fund for seven years. “The risk budget is a ‘variable variable’ in a way.”

While the internal management has discretion to make fairly substantial allocation changes at will, Breval is quick to point out these are not tactical, but decisions made based on risk.

“These are risk-driven decisions, or volatility-based decisions. They are not tactical by looking at asset class outlooks, even though we have opinions, they are not opinion-driven decisions.”

The AHV, for example, tends to have a higher risk budget, while the disability fund, which has $15 billion debt, has a more conservative allocation.

Overall the Federal Social Security Fund has 30 staff, about half of which are investment staff, which are now managing these three different funds on a risk budget basis.

The fund has separate teams for investment policy and active management, portfolio construction, internal and external mandates, as well as forex and cash management.

“Return is not the single key factor for us, the number one priority is paying the pensions, and maintaining a level of risk commensurate with the desired level of volatility for each social insurance,” Breval says.